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Should bank capital regulation be risk sensitive?

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  • Ahnert, Toni
  • Chapman, James
  • Wilkins, Carolyn

Abstract

We present a screening model of the risk sensitivity of bank capital regulation. A banker funds a project with uninsured deposits and costly capital. Capital resolves a moral hazard problem in the choice of the probability of default (PD). The project’s loss given default (LGD) is the banker’s private information. The regulator receives a noisy signal about the LGD and imposes a minimum capital requirement. We show that the optimal sensitivity of capital regulation is non-monotonic in the accuracy of risk assessment. If the signal is inaccurate, the regulator should use risk-insensitive capital requirements. Given sufficient accuracy, the regulator should separate types via risk-sensitive capital requirements, reducing the risk-sensitivity of bank capital as accuracy improves.

Suggested Citation

  • Ahnert, Toni & Chapman, James & Wilkins, Carolyn, 2021. "Should bank capital regulation be risk sensitive?," Journal of Financial Intermediation, Elsevier, vol. 46(C).
    • Handle: RePEc:eee:jfinin:v:46:y:2021:i:c:s1042957320300243
    DOI: 10.1016/j.jfi.2020.100870
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    4. Song, Fenghua & Thakor, Anjan, 2022. "Ethics, capital and talent competition in banking," Journal of Financial Intermediation, Elsevier, vol. 52(C).

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    More about this item

    Keywords

    Bank capital; Regulation; Risk sensitivity; Moral hazard; Adverse selection;
    All these keywords.

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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